Part Two: The Arithmetic of Option Premiums

At
the time you purchase a particular option, its premium cost may be
$1,000. A month or so later, the same option may be worth only $800 or
$700 or $600. Or it could be worth $1,200 or $1,300 or $1,400. Since an
option is something that most people buy with the intention of
eventually liquidating (hopefully at a higher price), it’s important to
have at least a basic understanding of the major factorswhich influence
the premium for a particular option at a particular time. There are
two, known as intrinsic value and time value. The premium is the sum of
these.

Premium = Intrinsic Value + Time Value

Intrinsic ValueIntrinsic
value is the amount of money, if any, that could currently be realized
by exercising the option at its strike price and liquidating the
acquired futures position at the present price of the futures contract.
At a time when a U.S.Treasury bond futures contract is trading at a
price of 120-00, a call option conveying the right to purchase the
futures contract at a below-the-market strike price of 115-00 would
have an intrinsic value of $5,000. An option that currently has
intrinsic value is said to be “in-themoney” (by the amount of its
intrinsic value). An option that does not currently have intrinsic
value is said to be “out-of-the-money.”

At a time when a
U.S.Treasury bond futures contract is trading at 120-00, a call option
with a strike price of 123-00 would be “out-ofthe-money” by $3,000.

Time ValueOptions
also have time value. In fact, if a given option has no intrinsic
value—because it is currently “out-of-the-money”—its premium will
consist entirely of time value.

What’s “time value?”It’s
the sum of money option buyers are presently willing to pay (and option
sellers are willing to accept)—over and above any intrinsic value the
option may have—for the specific rights that a given option conveys. It
reflects, in effect, a consensus opinion as to the likelihood of the
option’s increasing in value prior to its expiration.

The three principal factors that affect an option’s time value are:

1.
Time remaining until expiration. Time value declines as the option
approaches expiration. At expiration, it will no longer have any time
value. (This is why an option is said to be a wasting asset.)

2.
Relationship between the option strike price and the current price of
the underlying futures contract. The further an option is removed from
being worthwhile to exercise—the further “out-of-the-money” it is—the
less time value it is likely to have.

3. Volatility. The
more volatile a market is, the more likely it is that a price change
may eventually make the option worthwhile to exercise. Thus, the
option’s time value and therefore premium are generally higher in
volatile markets.

Past performance is not necessarily indicative of future results and the risk of loss does exist in futures trading. All trading rates quoted per side. Applicable exchange, regulatory, and brokerage fees apply to rates shown.